Income

JPMorgan JEPI ETF: Forget Capital Gains, Focus on High Income

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The JPMorgan Equity Premium Income ETF (NYSEARCA: JEPI) offers investors exposure to large-cap US equities, but with a significantly higher dividend yield, achieved largely by generating option premiums, and currently sits at nearly 11%. For USA investors, this ETF is very likely to outperform given the low returns that current S&P500 valuations imply. JEPI is an actively managed equity income ETF that holds derivatives and is therefore subject to more risk than traditional long-only ETFs. As the ETF has only been around for two years, there is also limited historical data to test its performance under different market conditions. However, overall I think the fund is a buy, especially for those looking to reduce volatility in their portfolio.

The JEPI ETF

The ETF seeks to provide the majority of the returns associated with the Fund’s primary benchmark, the S&P500, while exposing investors to less risk through lower volatility and still delivering high income. The ETF achieves this by creating a portfolio of equity securities with a lower level of volatility than the S&P500 and also investing in equity-linked bonds (ELNs). Under normal circumstances, the Fund invests at least 80% of its assets in equity securities, while ELNs represent up to 20% of the portfolio and generate premiums on the writing of call options. JEPI therefore uses a similar strategy to XYLD, which I covered last month (see ‘XYLD: A no-brainer alternative to SPX’), and the two ETFs have performed very similarly since JEPI’s inception. in June 2020.

Return JEPI vs. XYLD

JEPI versus XYLD, total return (Bloomberg)

The main difference is that JEPI uses an active management strategy, where fund managers use a bottom-up research process with stock selection based on our proprietary risk-adjusted stock rankings. This is another attractive feature of the ETF compared to the XYLD, as it means less exposure to expensive segments of the market such as technology, as well as reduced concentration risk, as the top 10 stocks do not represent only 18% of total assets compared to 27%. for XYLD. Additionally, JEPI has a slightly lower expense ratio of 0.35% compared to 0.6% for XYLD.

JEPI ETF Main securities of the sector

JEPI Top Industry Holdings (Bloomberg)

Top XYLD Industry Stocks

XYLD Top Industry Holdings (Bloomberg)

Why the JEPI strategy is now attractive

I particularly like the call option writing strategy to generate income in today’s market where US equities are overvalued. As I explained yesterday in ‘SPX: Dip Buyers Beware’, the S&P500 remains priced for negative total returns over the next few years due to still extreme valuations, and the 1.6% dividend yield is too low. to offset the risk of capital loss. The main disadvantage of JEPI and other equity income ETFs is that they underperform during bull markets. However, as we have seen over the past few months, the high revenues generated allow them to outperform during weak stock markets.

S&P 500 valuation versus subsequent returns

S&P500 valuation vs later returns (Bloomberg)

The ETF’s current 30-day SEC yield, received through the combination of dividends on its stock holdings and options premium income, is 10.7%, more than 9pp higher than the S&P500. himself. This implied that for the JEPI to underperform the S&P500, the latter would need to continue to post returns well above the growth of the economy, which is showing trend nominal GDP and sales growth of around 4%. . This means that S&P500 valuations would need to rise further from current extremes for the index to outperform the JEPI. Even if this were the case, JEPI’s equity holdings would also rise sharply, allowing the fund to generate strong returns.

Risks to consider

The actively managed nature of the fund and the use of ELNs mean that there are additional risks associated with JEPI compared to the S&P500. There is no guarantee that fund managers will be able to select stocks with a lower level of volatility than the S&P500, and the fact that the ETF’s stock holdings differ significantly from the S&P500 means that it could significantly underperform its benchmark in the short term.

However, perhaps the main risk arises from the use of derivatives. As explained in the ETF’s prospectus, if the prices of the underlying instruments move unexpectedly, the Fund may not realize the expected benefits of investing in an ELN and may suffer losses, which could be material. and could include the entire capital of the Fund. investment. Investments in ELNs are also subject to liquidity risk, which can make them difficult to sell and to value. A lack of liquidity can also cause the value of the ELN to decline. In addition, ELNs may exhibit price behavior that is not correlated with the underlying securities. The Fund’s ELN investments are subject to the risk that issuers and/or counterparties may fail to make payments when due or default altogether. The prices of the Fund’s ELN investments may be adversely affected if any of the issuers or counterparties in which it invests are subject to an actual or perceived deterioration in their credit quality.

The fact that the ETF has only been around for two years also means that there isn’t much track record to gauge the fund’s performance in adverse credit market conditions, as we saw during the global financial crisis. For these reasons, I would recommend investors hold JEPI as part of a larger diversified portfolio. Nonetheless, from a risk-reward perspective, the ETF should outperform, especially for US-focused investors.